Looking Back & Forward
S&P Tests 1100 but Erases Gains: The market fell 2.0% in October, the first down month since February when the S&P 500 fell 11.0%. Mid-month the S&P was up
as much as 3.9%, and even broke 1100 twice intra-day, before erasing all of its gains by month-end. We do not think the current correction is the beginning of a
wider or more severe sell-off in risk assets.
Economic data has been patchy over the past two weeks, justifying some concern about the momentum in the recovery, but we would be more concerned if equity
weakness was accompanied by a significant rally in bonds (ie: growth concerns have accelerated), further dollar declines, a large spike in the price of crude oil, or a
major steepening in the yield curve. We still expect momentum in LEI’s to be supportive for risk assets in the near-term and the ISM – while slowing it’s rate of accent
– is still likely to remain above 50 and in expansionary territory.
Over the month, crude oil rallied 9.0% and natural gas rose 4.2%. Risk trades generally underperformed, with large caps outperforming small caps and growth
outperforming value, although emerging markets outperformed developed markets. Volatility rose 19.8% in October with the VIX ending at 30.7. The MS Global Risk
Demand Index was up 2.4% over the month, after it fell 2.0% from its Oct 22nd peak.
Risk assets remain supported by improving growth momentum, rates on hold, and liquidity measures which are plentiful (pg 19). It is clear that the 3Q reporting
season is not providing the upside catalyst that was hoped for going into year-end, but it has also not been enough to provide additional confirmation that corporate
America remains well positioned if revenue growth begins to pick up. We are more concerned with the market internals – loss of leadership by Financials and
Technology which have been and are essential for taking the market higher into year-end.
Equity valuations are not stretched and remain close to the long-term average (pg 47). The Graham-Dodd P/E is at 16.3x and our COV model implies that 18.6% of
value is being driven by future earnings. Market sentiment worsened this month (pg. 53) although some indicators remain neutral (Nasdaq net speculative positions,
AAII Bull/Bear Ratio) while other indicators have moved into bearish territory (Consensus Inc. Weekly % bullish stocks survey, CBOE Put/Call Ratio). Additionally,
our MS Capitulation Indicator turned down this month for the first time since Oct 2008. We continue to believe that the low valuation dispersion between high and low
quality stocks means the best value is found in the former. This trade worked well over the month.
3Q09 Earnings Season – Bottom-line Beating Again: To date, 323 companies representing 74% of S&P 500 market cap have reported earnings. Of these, 55%
of companies have beat earnings estimates by more than 5%. Ex-financials, earnings are 7.1% higher than consensus, even though revenues are 1.0% below
expectations, implying that the cost-out theme continues to be the primary driver of better than expected earnings. Our aggregate S&P income statement on page 12
shows that EBITDA margins are a full percentage point above expectations (earnings are highly levered to margins). We doubt the sustainability of these margins.
3Q09 EPS is now running at $15.19 (using actual earnings for companies that have reported and consensus estimates for the rest), down 3.7% y/y, much better than
the $14.57 (-9% y/y) expected earnings before the reporting season began.
As we would expect, companies that have had positive earnings surprises that are followed by positive earnings revisions have performed better (+1.1% on average
in the following three days) than companies that have just beaten (+0.6%). The market has punished downside surprises slightly more (-0.8%) than it has rewarded
the beaters. Among companies that have beat earnings, those with top-line beats have performed better (+0.5% on average in the following three days) than those
with cost, or margin, beats (-0.4%).